October 29, 2006
Microfinance and Third World Poverty and Development
Microfinance and Third World Poverty and Development--Posner
The award earlier this month of the Nobel Peace Prize to Muhammad Yunus and his Grameen Bank of Bangladesh has directed attention to the phenomenon of microfinance, which Yunus and his bank have pioneered. The term refers to the making of tiny loans to poor people in underdeveloped countries, like Bangladesh. The amounts are sometimes only tens of dollars, the borrowers are small farmers, shopkeepers, artisans, and other minute commercial enterprises--overwhelmingly female (97 percent)--and the interest rates, which are designed to compensate the lenders fully, are high—sometimes as high as 20 percent a day. Although Yunus's motivation is not primarily commercial, the high interest rates and a relatively low default rate (in part because groups of women related to or friends with the borrower often agree to guaranty repayment of the loan), said to be only 1 percent, enable the Grameen Bank and its imitators (collectively referred to as "MFIs"--microfinance institutions--to cover their costs. The MFIs provide other services to poor entrepreneurs as well, but the loans ("micrcredit") are the most interesting feature of this experiment in helping poor countries throw off their poverty.
Microfinance began with the Grameen Bank in the 1980s, and to date the bank has disbursed almost $6 billion in loans to some 6 million people. The total number of borrowers from all microfinance institutions is expected to reach 100 million by next year. The aggregate value of these loans is a drop in the bucket so far as alleviating Third World poverty is concerned, but the award of the Nobel Prize is a vote of confidence that may encourage continued growth of the program.
What exactly microfinance has to do with "peace" is obscure. The causes of war are complex, and it is by no means clear that poverty is a major one. In any event the actual contribution of microfinance to peace must be slight and speculative.
So the award of a Nobel Peace Prize to Yunus was questionable, but that is not to criticize Yunus's project. The experiment is a worthy one, though its success has yet to be demonstrated despite glowing appraisals by Kofi Annan and others. It may simply be the latest development fad.
It does however seem superior to philanthropy in the sense of handouts, which in this case would mean giving grants (or heavily subsidized loans) to small entrepreneurs on the basis of competitive applications. For that is a competition in rhetoric. Middlemen would spring up to assist the applicant in writing a persuasive application, and the fees charged by the middlemen would be a good example of how the prospect of obtaining economic rents (crudely, something for nothing) channels the expected rents into costs. And the grants would frequently be misallocated. The high interest rates that the microfinanciers charge induce self-selection by the borrowers: a borrower has to have confidence in the project for which he is seeking microcredit in order to be willing to assume the burden of servicing his debt. Of course such confidence is sometimes, and perhaps among the poor often, misplaced.
An obvious question is why, if microfinance is remunerative, commercial banks and other commercial lenders did not enter the market long ago; for as I said, microfinance began in the 1980s. One possibility is that regulations designed to protect the solvency of banks limits their ability to make risky loans. Usury laws may be an obstacle too, if they are differentially applied to ordinary lenders as distinct from microfinanciers--yet the Grameen Bank seems to be an ordinary stock corporation, not a nonprofit. More important may be the existence of a close substitute for microfinance in the form of informal loans by relatives and clan members, a method of financing that is feasible (and extremely common) in societies in which the clan and the extended family can discipline members by threat of ostracism and other informal sanctions. The total capital possessed by the family or clan might be slight by usual commercial standards, yet if only one or a few members have any real entrepreneurial prospects, the limited capital may be sufficient to finance their tiny projects. So microfinance is perhaps best understood as a device for easing the transition from an economy based on trust to a normal commercial society.
As a substitute for trust, microfinance has obvious drawbacks. Extremely high interest rates, though justified not only by the risk of default (and the opportunity cost of money, that is, the riskless interest rate) but also by the very high transaction costs of a tiny loan (since those costs are largely fixed, rather than varying with the size of the loan), burdens the borrower with very heavy fixed costs, since he must repay the loan regardless of the success of his enterprise. The higher a producer's fixed costs relative to his total costs, the riskier his enterprise, since if demand for his product falls or his marginal costs rise he will find it extremely difficult to adjust by cutting output; the cut will reduce the revenue out of which he has to pay principal and interest on the loan. Borrowing at astronomical interest rates seems an unlikely formula for commercial success--and the more unlikely the poorer the borrower.
In the family or clan alternative, trust may provide an extremely low-cost substitute for the transaction costs involved in microfinance. Perhaps then microfinance will occupy a narrow niche in capital markets between family and clan resource pooling at one end and commercial lending at the other. Indeed, the fact that the overwhelming majority of microfinance borrowers are women suggests that the particular market failure that microfinance corrects is discrimination against women in the family and clan capital markets.
An alternative form of microfinancing would be equity rather than debt financing, on the model of private equity firms like Blackstone and the Carlyle Group. Of course these multibillion dollars firms have no interest in making $100 loans in Bangladesh. But the Grameen Bank could presumably furnish equity in lieu of loans to its customers, thus sharing the risk with them and so reducing the risk to them; and it is a superior risk sharer because of size and diversification. But maybe the bank would find it too difficult to evaluate projects, or would fear being inundated by applications from the impecunious.
I end on a skeptical note. The evidence for the efficacy of microfinance in stimulating production and alleviating poverty is so far anecdotal rather than systematic. The idea of borrowing one's way out of poverty is passing strange. And I am unaware of any historical examples of nations that climbed out of poverty on the backs of small entrepreneurs financed by credit. Also, recall that Grameen Bank has lent almost $6 billion to some 6 million persons. This implies an average loan of almost $1,000, which in a country like Bangladesh is not chicken feed and makes one wonder how much of the Grameen Bank's loan portfolio is actually microfinance. (Yet the bank's financial statement indicates that the average loan balance in 2005 was only $85--I don't understand how this squares with the aggregate figures that I gave above, which are also published by the bank!) Then too, the bank has been in operation since 1983, which is more than 20 years and indicates that the average number of borrowers is only 300,000 a year, with presumably many repeat borrowers. Bangladesh has a population of almost 150 million people. It is true that the microfinance movement is growing--and as it grows we may see default rates rising and the microfinanciers adjusting, as the Grameen Bank may already have done, by greatly increasing the minimum size of loans. Think back to that low default rate for the Grameen Bank. The bank does not have written loan agreements and does not sue defaulters or invoke other legal remedies against them. The natural inference to draw is that the bank is extremely selective in its choice of persons to whom it is willing to lend, and such selectivity, if imitated by other microfinanciers, must greatly limit the scope and impact of microfinance.
I suggest, albeit tentatively, that there may be a good less to microfinance than its boosters claim.
Comment on Microfinance-BECKER
I applaud the granting of the Nobel Peace Prize to Muhammad Yunus and the Grameen Bank. Sure, reducing poverty has at most an indirect connection with peace by encouraging democracy. Still, the Peace Nobel prize has often been so political- it is different from other Nobel Prizes since the Peace Prize is awarded by the Norwegian Parliament- and frequently of such dubious merit, that it is a welcome change to have the Prize given to someone who has really helped the very poor of the world.
Yet, all economists who have studied microfinance agree that it will never be more than a minor factor in ending poverty in any country. Economic growth requires secure property rights, encouragement of private enterprise, openness to international trade, stimulation of education, limited and sensible regulations, and reasonably honest government. Microfinance makes only a small direct contribution to any of these variables.
However, microfinance does accomplish something useful, and that is how it should be evaluated. So far microfinance has been mainly oriented toward women, although itthat is not necessary. It started in the primarily Muslim rural areas of Bangladesh, where women had great difficult borrowing money in any way to earn income as tiny scale entrepreneurs. Study of several of these programs suggest that in fact payback rates have been high since borrowers have been subject to great social pressure to repay, they have few alternative ways to borrow, and because of other factors. These studies also suggest that women who borrow gain bargaining power within their families. This shows up as an increase in the education of daughters and also sons, greater spending on medicines, and on women's assets, like gold, in families that have women who borrowed under one of these programs.
These programs are usually quite flexible, and sometimes approach the equity type loans that Posner advocates. If someone is having trouble repaying debt due to no fault of her (or his) own, microfinance lenders, as well as other lenders in these communities, often wait until times get better, instead of demanding all payments be made on time. In effect, microfinance often work out to be loans with returns that are quite sensitive to how well borrowers do.
Microfinance has spread to rural parts of non-Muslim countries, and these loans too are primarily given to women. Evaluations of the effects of loans in non-Muslim countries also show high repayment rates, and that female borrowers repay at higher rates than, and generally outperform, male borrowers. So loans in other countries appear to have similar effects as in Muslim countries like Bangladesh.
I do not believe there is much of a puzzle about why commercial institutions have not made such micro loans. For one thing, enforcement of repayment by any particular borrower from the group of all borrowers in a local area was originated by the Grameen Bank, and would not be easily copied by for-profit banks and moneylenders. But even if commercial lenders could have the same high repayment rates, these loans have not typically earned the rates of return required by commercial lenders in poor countries. The Grameen Bank and other groups active in making micro loans have had some financing from NGO's that do not seek to make commercial returns on their spending. So my belief is that despite the seemingly "high" interest rates on these loans, they have earned returns, adjusted for servicing, risk, and other costs, that are below market interest rates in their respective countries,
If private groups want to make gifts to rural women in poor countries, making them through micro loans is a much better way than many alternatives. Loans at considerable interest rates aid donors select among a huge number of persons who believe they deserve help. For by requiring recipients to engage in productive activities that yield enough returns to pay interest and repay principal, micro loans in effect choose to help those with ideas and a willingness to work hard. What is a better way to choose among too many people who are really poor? In my judgment, it is always better as far as possible to reward people who try to help themselves.
The focus on women may be a good starting point in many countries since they have entrepreneurial ideas, and yet often have great difficulty in borrowing commercially, or even from their families. Still, one risk here is that the apparent borrower is a woman, but the real borrower is her husband, brother, or father, and she is simply a front for them. Moreover, many men in poor rural areas also have great difficulty getting access to funds, so these programs should include many more male borrowers as they grow in scope.
Individuals like Pierre Omidyar, one of the founders of eBay, has made a $100 million contribution to Tufts University for that university to invest in profit-making microfinance programs. I share his apparent belief in the principle that competition among for-profit firms is the best way to organize and allocate resources in an economy. It may be possible to get a fully for-profit sector that has large resources, and makes the small micro loans pioneered by the Grameen Bank. I hope so, but the many for-profit moneylenders and banks in poor countries in the past did not manage to make such small loans at rates that were both profitable and appealing to borrowers. So I am not convinced that his vision and that of some other American entrepreneurs will be successful. But their vision of harnessing incentives from the for-profit sector is the right way to try to improve microfinance.